Restraining Government in America and Around the World

Five Lessons from Ireland

The news is going from bad to worse for Ireland. The Irish Independent is reporting that the Swiss Central Bank no longer will accept Irish government bonds as collateral. The story also notes that one of the world’s largest bond firms, PIMCO, is no longer purchasing debt issued by the Irish government.

1. Bailouts Don’t Work – When Ireland’s government rescued depositors by bailing out the nation’s three big banks, they made a big mistake by also bailing out creditors such as bondholders. This dramatically increased the cost of the bank bailout and exacerbated moral hazard since investors are more willing to make inefficient and risky choices if they think governments will cover their losses. And because it required the government to incur a lot of additional debt, it also had the effect of destabilizing the nation’s finances, which then resulted in a second mistake – the bailout of Ireland by the European Union and IMF (a classic case of Mitchell’s Law, which occurs when one bad government policy leads to another bad government policy).

American policy makers already have implemented one of the two mistakes mentioned above. The TARP bailout went way beyond protecting depositors and instead gave unnecessary handouts to wealthy and sophisticated companies, executives, and investors. But something good may happen if we learn from the second mistake. Greedy politicians from states such as California and Illinois would welcome a bailout from Uncle Sam, but this would be just as misguided as the EU/IMF bailout of Ireland. The Obama Administration already provided an indirect short-run bailout as part of the so-called stimulus legislation, and this encouraged states to dig themselves deeper in a fiscal hole. Uncle Sam shouldn’t be subsidizing bad policy at the state level, and the mess in Europe is a powerful argument that this counterproductive approach should be stopped as soon as possible.

2. Excessive Government Spending Is a Path to Fiscal Ruin – The bailout of the banks obviously played a big role in causing Ireland’s fiscal collapse, but the government probably could have weathered that storm if politicians in Dublin hadn’t engaged in a 20-year spending spree.

The red line in the chart shows the explosive growth of government spending. Irish politicians got away with this behavior for a long time. Indeed, government spending as a share of GDP (the blue line) actually fell during the 1990s because the private sector was growing even faster than the public sector. This bit of good news (at least relatively speaking) stopped about 10 years ago. Politicians began to increase government spending at roughly the same rate as the private sector was expanding. While this was misguided, tax revenues were booming (in part because of genuine growth and in part because of the bubble) and it seemed like bigger government was a free lunch.

Eventually, however, the house of cards collapsed. Revenues dried up and the banks failed, but because the politicians had spent so much during the good times, there was no reserve during the bad times.

American politicians are repeating these mistakes. Spending has skyrocketed during the Bush-Obama year. We also had our version of a financial system bailout, though fortunately not as large as Ireland’s when measured as a share of economic output, so our crisis is likely to occur when the baby boom generation has retired and the time comes to make good on the empty promises to fund Social Security, Medicare, and Medicaid.

3. Low Corporate Tax Rates Are Good, but They Don’t Guarantee Economic Success if other Policies Are Bad – Ireland used to be a success story. They went from being the “Sick Man of Europe” in the early 1980s to being the “Celtic Tiger” earlier this century in large part because policy makers dramatically reformed fiscal policy. Government spending was capped in the late 1980 and tax rates were reduced during the 1990s. The reform of the corporate income tax was especially dramatic. Irish lawmakers reduced the tax rate from 50 percent all the way down to 12.5 percent.

Unfortunately, good corporate tax policy does not guarantee good economic performance if the government is making a lot of mistakes in other areas. This is an apt description of what happened to Ireland. The silver lining to this sad story is that Irish politicians have resisted pressure from France and Germany and are keeping the corporate tax rate at 12.5 percent. The lesson for American policy makers, of course, is that low corporate tax rates are a very good idea, but don’t assume they protect the economy from other policy mistakes.

4. Artificially Low Interest Rates Encourage Bubbles – No discussion of Ireland’s economic problems would be complete without looking at the decision to join the common European currency. Adopting the euro had some advantages, such as not having to worry about changing money when traveling to many other European nations. But being part of Europe’s monetary union also meant that Ireland did not have flexible interest rates.

Normally, an economic boom drives up interest rates because the plethora of profitable opportunities leads investors demand more credit. But Ireland’s interest rates, for all intents and purposes, were governed by what was happening elsewhere in Europe, where growth was generally anemic. The resulting artificially low interest rates in Ireland helped cause a bubble, much as artificially low interest rates in America last decade led to a bubble.

But if America already had a bubble, what lesson can we learn from Ireland? The simple answer is that we should learn to avoid making the same mistake over and over again. Easy money is a recipe for inflation and/or bubbles. Simply stated, excess money has to go someplace and the long-run results are never pleasant. Yet Ben Bernanke and the Federal Reserve have launched QE2, a policy explicitly designed to lower interest rates in hopes of artificially juicing the economy.

Since we just endured a financial crisis caused in large part by a corrupt system of housing subsidies for Fannie Mae and Freddie Mac, American policy makers should have learned this lesson already. But as Thomas Sowell sagely observes, politicians are still fixated on somehow re-inflating the housing bubble. The lesson they should have learned is that markets should determine value, not politics.

34 Responses

“…so our [American] crisis is likely to occur when the baby boom generation has retired and the time comes to make good on the empty promises to fund Social Security, Medicare, and Medicaid.”

Mr. Mitchell,
You forgot the emerging most redistributive pillar of the Welfare State: ObamaCare.

When Social Security and Medicare were implemented, there was significant opposition to these programs. Now what percentage of the population supports cuts in these programs? 10% ? 15%.

Why would anyone think that ObamaCare will follow a different trajectory ? or that somehow America alone amongst 200 nations on this planet wills somehow escape the grip of Mitchell’s law?

Prove me wrong dear Americans and I will once again believe in American Exceptionalism. Otherwise, with mathematical precision, fade away into worldwide averagedom in 20-40 years. That will be the overriding geopolitical story of the first half of the 21st century. One big question is whether this American fade- away will happen as a series of intense crises separated by relative calm or whether it will happen as a slow decline. The US housing bubble and European sovereign debt crisis point towards the first scenario, so far.

“…This [increased government revenue in response to lower tax rates] was remarkable since it is only in very rare cases that the Laffer Curve means a tax cut generates more revenue for government…”

Rare in the short term, that is. In the longer term, in most cases, eventually, a tax cut generates more revenue for government simply because of the unrelenting compounding advantage of higher economic growth. This compounding is essentially how the American lower class ended up better off than the Soviet upper class. It is amazing how rarely this distinction between short and long term Laffer Curve effects is made. It takes time for growth rate compounding to catch up and, to some extent, it also takes time for people to make more permanent lifestyle changes in response to different incentives to be productive.

Why should depositors be entirely insulated from haircuts. The same moral hazard that exists with bond holders, and more, exists with depositors. Incentivized to put their money in those institutions that take the biggest risks for a tad bit more interest, i.e. without ever bothering to evaluate the risk/rearward ratio, since the risk is assumed by the FDIC i.e. spread out to everyone through a higher cost of banking (fees) and eventually as we have seen in crises, by taxation. Hence, there has been no demand and thus no consumer market for bank safety and consequently no market for mere consumer/depositor information on bank safety either. When is the last time you sought information on the health of your bank?

Money market mutual funds are not insured and depositors are subject to haircuts. Yet, how many have defaulted over the years? Two perhaps have given a 2-3% depositor haircut in 40 years? Contrast that to the S&L crisis of the 80’s and the current investment banking crisis.

Look for future crises as we all collectively support masking fundamental physical realities, collectivizing the risk/reward ratio and pursue the utopia of prosperity through someone else’s work and/or goodwill.

So let me repeat the mantra: There is simply no way to maintain incentives to produce and the simultaneous pursuit of competing alternatives under big government. You can, to some extent, compensate for the lower incentives to produce and government imposed homogeneity by forcing the population as a whole to become individually more competent (primarily more educated) as Europe does. But why go through this entire circle to end up somewhat worse than where you started? In a nutshell: The more individually independent Dumb Americans (as the rest of the world knows them) still beat the herded European Rocket Scientists. But an ever increasing number of American Useful Idiots want to copy Europe’s dirigistic policies. Good luck folks. As, you end up hauling two kids in and out of public transportation between your new mandated 900sqf apartments in highly regulated dense cities, you’re gonna long for your past days in dumb redneck pickup freedom.

[…] And the icing on this unpalatable cake was the decision to engage in the “Mother of all Bailouts” when the big banks became insolvent. That meant not just holding depositors harmless, but also bailing out all bondholders as well. […]

[…] growth and look what happened.” To be sure, most of those folks would make those accusation even if I produced comprehensive analysis of Ireland’s good and bad policies. But I now try to be more careful so I don’t have to engage in after-the-fact […]